Fed Tapering Is No Big Deal and Here's Why

NEW YORK (TheStreet) -- The majority consensus seems to be the Federal Reserve's tapering of its bond purchases, or quantitative easing, will be problematic for the stock and bond markets. I'm not so sure.

"...everything ends badly, otherwise it wouldn't end." -- Cocktail (1988)

Stocks finally displayed some real vulnerability on Monday -- though after January's weakness thus far I don't think too many investors were surprised. Wrong-footed, yes, but not surprised. We have been due, or overdue, for a stock market correction for quite some time. Money doesn't flow in one direction forever.

There is something meaningfully different today than one or even two years ago, and that is the rate on the 10-year Treasury. Two years ago we were at 1.85%; one year ago we were still at 1.85%. Today we are a full percent higher at 2.85%. Now that may not sound earth-shattering to you, but it most certainly is for pension funds and fixed income mutual funds.

For the past several years bonds of all shapes and sizes have been called as issuers -- from municipalities to corporations -- have taken advantage of what Fed Chairman Ben Bernanke has given them. That is an opportunity to reduce cost of capital, in some cases dramatically, at the expense of bond investors.

Many bonds have call features that allow the issuer the ability to refinance its debt. Naturally this happens when interest rates decline. Victims of this phenomenon are the bondholders whose bonds get called. They are paid in cash (not literally) and then must seek out opportunities to reinvest that are just as good as their old bond. Since rates have fallen, there aren't any; the investor will need to accept smaller interest payments and/or more credit risk.

Another option is to sit in cash and wait for rates to normalize a bit.

"Don't just sit there, do something!"

Over the past few years, pension funds and "balanced" mutual funds have watched their allocation to stocks bubble up to uncomfortable levels, partly because they have been the more attractive asset class and partly from organic growth. These funds have an interest in reducing their equity exposure and locking in gains, and what a great time to do it (at least in relative terms).

For the first time in 30 months there is a semi-attractive alternative to equities for these funds and investors. Just take a look at what has happened to the 10-year Treasury each time it has played peek-a-boo with 3% over the past four months.

10 Year Treasury Rate Chart
10 Year Treasury Rate
data by YCharts


What does the bond market have to do with a stock market correction?

It takes a little reverse engineering but I believe the bond market has everything to do with the magnitude of the current stock market correction. A correction of any serious proportions will likely cause enough of a rotation -- this time from equities to bonds -- to push yields right back down to a more stock market-friendly level. Effectively, the exact same result we have seen from quantitative easing.

Is there really enough money in these pension funds to counter-balance the Fed's withdrawal? Yes. According to Bloomberg, in the third quarter of 2013 alone, public and private pension funds here in the U.S. added $117 billion to their collective fixed-income allocations -- withdrawing $135 billion from stocks. And that's just an appetizer.

What if rates don't rise this year?

A major concern among investors and advisers today has to do with positioning their portfolios for the inevitability that interest rates will rise. We are hearing about how bonds should be avoided and anything bond-like should treated with equal hesitation. This would be the correct view if rates were to rise dramatically from here. But what if they don't?

It's possible stocks and bonds will both have a bit of a seesaw year due to the argument outlined above. Look for upside surprises in securities and sectors where -- because of a fear of rising rates -- prices have become unfairly depressed. The very positions that got hurt most during last May's so-called "taper tantrum" might be a great bet if this premise holds true. 

Consider select master-limited partnerships with long histories of stable distributions. These include Amerigas Partners (APU), Buckeye Partners (BPL), Kinder Morgan Energy Partners (KMP) and Williams Partners  (WPZ) for individual stock exposure (and a K-1).

There is also an exchange-traded note representing the index, JPMorgan Alerian MLP Index ETN (AMJ), which generates a 1099. A more controversial call might be Vanguard REIT ETF (VNQ) or that index's single largest holding, Simon Property Group (SPG), both of which look inexpensive.

At the time of publication the author is long APU, BPL, KMP, WPZ and VNQ.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

More from Opinion

It's Just Not Smart For Investors to Ignore the Threat of a Trade War

It's Just Not Smart For Investors to Ignore the Threat of a Trade War

To Think a Trade War's Still Just a Threat Is the Dumbest Thing on Wall Street

To Think a Trade War's Still Just a Threat Is the Dumbest Thing on Wall Street

Flashback Friday in Politics: Trade Wars, Manafort, Immigration Dominate Minds

Flashback Friday in Politics: Trade Wars, Manafort, Immigration Dominate Minds

Microsoft and Sony's Rumored Game Console Plans Bode Well for AMD

Microsoft and Sony's Rumored Game Console Plans Bode Well for AMD

Apple Supplier Jabil Is Tumbling, But Its Sales Momentum Remains Strong

Apple Supplier Jabil Is Tumbling, But Its Sales Momentum Remains Strong